Strategic Financial Management · Risks in Financial Market

Interest Rate Risk and Exchange Rate Risk Explained

Updated 11 October 2026 · Fact-checked

Interest rate risk is the chance that a change in market rates changes the value or cash flows of your assets and liabilities. Exchange rate risk is the chance that currency movements change your rupee outcomes. To solve questions, identify the exposure, quantify the gain or loss, then pick and compare hedges.

Understand Interest Rate Risk and Exchange Rate Risk

Interest rate risk arises because rates move. If you hold a fixed-rate bond, a rise in market rates cuts its price. If you have a floating-rate loan, a rise in rates raises your interest cost. So the same rate change can hurt a lender or a borrower, depending on how the balance sheet is built.

There are two sides. Price risk is the fall in the market value of fixed-income assets when rates rise. Reinvestment risk is the chance that cash flows, such as coupons, are reinvested at lower rates. A mismatch between the repricing dates of assets and liabilities is called a gap. Banks track this closely.

Exchange rate risk arises when you have cash flows, assets or liabilities in a foreign currency. If an Indian importer owes US$ 1,00,000 in three months and the dollar becomes costlier in rupees, the payment costs more. An exporter faces the opposite problem when the foreign currency weakens.

Exposure is classified in three types.

Transaction exposure: the effect of rate changes on actual contracted cash flows, such as receivables, payables and foreign loans. It is a real cash effect.
Translation exposure: the effect on reported figures when a foreign subsidiary's statements are converted into the parent's currency. It is an accounting effect, not a direct cash flow.
Economic exposure: the effect on the present value of future operating cash flows and competitive position because of long-term currency shifts. It is the hardest to measure and hedge.

Once exposure is identified, the firm chooses a hedge. Internal methods include invoicing in the home currency, netting and leading and lagging. External methods include forwards, money market hedges, futures, options and swaps.

Key rules to remember

Forward premium or discount (annualised): (Forward − Spot) ÷ Spot × (12 ÷ months) × 100; Use direct quotes (₹ per unit of foreign currency). Positive means the foreign currency is at a premium.
Interest rate parity (approximate): Forward ÷ Spot = (1 + i home) ÷ (1 + i foreign); Use rates for the same period. Use the exact form when the question gives period rates.
Purchasing power parity (relative): Expected spot = Spot × (1 + inflation home) ÷ (1 + inflation foreign); Direct quote only. Inflation rates must be for the same period.
Money market hedge for a payable: Amount to deposit today = Foreign payable ÷ (1 + foreign deposit rate for the period); buy that at spot using rupees; Compare the rupee cost with the forward cost.
Money market hedge for a receivable: Borrow foreign amount = Receivable ÷ (1 + foreign borrowing rate for the period); convert at spot and invest in rupees; Compare the rupee value at maturity with the forward proceeds.
Approximate price change from rate change: % change in price ≈ −Modified duration × change in yield; Valid for small yield changes. Convexity corrects larger moves.
Rate gap: Gap = Rate-sensitive assets − Rate-sensitive liabilities; Change in net interest income ≈ Gap × change in rate, for a given period.

How to solve Interest Rate Risk and Exchange Rate Risk questions

Use this sequence for any question on interest rate or exchange rate exposure.

1Identify who is exposed: importer, exporter, lender, borrower or parent company. Note the direction of the cash flow.
2Classify the exposure as transaction, translation or economic, or as price, reinvestment or gap risk.
3Check the quotation basis. Convert to a direct quote (₹ per foreign unit) and note bid and offer rates.
4Quantify the unhedged outcome: the rupee cost or receipt at the expected spot, or the change in interest cost or value.
5Compute each hedge available: forward, money market, option or swap, using the correct period rates.
6Compare outcomes on the same date, with the same units and same time value.
7Give a clear recommendation and mention residual risks, such as counterparty, basis or cost of the option premium.

Quickest way: Compare forward and money market in two lines

When to use it: Use when the question asks for the cheapest way to hedge a single foreign currency payable or receivable.

Write the forward rupee amount first: foreign amount × relevant forward rate (offer rate for payable, bid rate for receivable).
Write the money market amount: discount the foreign amount at the foreign rate, convert at spot, then carry it to the due date at the rupee rate.
Pick the lower cost for a payable or the higher receipt for a receivable.
Write one sentence of recommendation. Marks are awarded for the decision.

Common mistakes in Interest Rate Risk and Exchange Rate Risk

Treating translation exposure as a cash loss.
The rupee value of the subsidiary falls, so it looks like a real loss.
Fix: State that translation exposure is an accounting effect unless the assets are sold or cash is remitted. Transaction exposure is the cash effect.
Using the wrong side of a bid-offer quote.
Students forget that the bank quotes from its own side.
Fix: The importer buys foreign currency at the bank's offer rate. The exporter sells at the bank's bid rate.
Using annual interest rates for a three-month hedge.
The period is not adjusted in a hurry.
Fix: Convert annual rates to period rates (annual × months ÷ 12) before discounting or compounding.
Comparing hedge outcomes on different dates.
The money market cost is paid today, while the forward cost is paid later.
Fix: Carry the money market cost to the due date at the rupee rate, or discount the forward cost to today.
Saying a rise in interest rates always hurts a firm.
Students remember bond price falls and forget floating-rate assets.
Fix: Check whether the firm is a net payer or receiver of floating interest, and check the gap.
Ignoring economic exposure in a theory answer.
It has no formula, so it gets skipped.
Fix: Describe it in terms of competitiveness, future operating cash flows and long-term currency trends, and name a few strategies such as diversifying markets and production locations.

Worked examples

Example 1

An Indian importer must pay US$ 2,00,000 in 3 months. Spot is ₹83.00/US$ and the 3-month forward is ₹83.60/US$. The US 3-month deposit rate is 4% p.a. and the rupee borrowing rate is 9% p.a. Compare the forward hedge with the money market hedge and recommend one. Ignore transaction costs and use simple interest.

Show the solution

Forward cost = 2,00,000 × 83.60 = ₹1,67,20,000, payable in 3 months.
Money market: the US 3-month rate is 4% × 3 ÷ 12 = 1%.
Dollars to deposit today = 2,00,000 ÷ 1.01 = US$ 1,98,019.80 (approximately).
Rupees needed today = 1,98,019.80 × 83.00 = ₹1,64,35,643 (approximately).
The rupee 3-month rate is 9% × 3 ÷ 12 = 2.25%. Borrowing this amount, the cost at 3 months = 1,64,35,643 × 1.0225 = ₹1,68,05,000 (approximately).
Compare: forward ₹1,67,20,000 against money market about ₹1,68,05,000. The forward is cheaper by about ₹85,000.

Answer: Choose the forward contract. It costs ₹1,67,20,000 against about ₹1,68,05,000 under the money market hedge.

Example 2

A bank has rate-sensitive assets of ₹900 crore and rate-sensitive liabilities of ₹1,200 crore in the 1-year bucket. Rates rise by 1 percentage point across the board. Find the gap and the approximate change in net interest income, and say what the bank should do if it expects rates to rise.

Show the solution

Gap = 900 − 1,200 = −₹300 crore. The bank is liability-sensitive.
Change in net interest income ≈ Gap × change in rate = −300 × 1% = −₹3 crore.
Interpretation: more liabilities than assets reprice at the higher rate, so interest cost rises faster than interest income.
If rates are expected to rise, the bank should reduce the negative gap. It can shorten asset repricing periods, add floating-rate assets, lengthen liability repricing, or use an interest rate swap to pay fixed and receive floating.

Answer: Gap is −₹300 crore and net interest income falls by about ₹3 crore. The bank should move towards a zero or positive gap before rates rise.

Exam tips

In MCQs, the distinction between transaction, translation and economic exposure is a frequent test. Remember: cash contracts, accounting conversion, long-term competitiveness.
In numerical questions, write the quotation basis and which side of the bid-offer you use. This earns method marks even if arithmetic slips.
Always end a hedge comparison with a recommendation and one risk. The paper looks for decisions, not only workings.
For theory, structure your answer as meaning, type, example and hedging method. Short examples with rupees and Indian firms read well.
Keep period rates consistent. Write the conversion line from annual to period rate in your working.

Practice questions from Risks in Financial Market

Interest Rate Risk and Exchange Rate Risk in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Interest Rate Risk and Exchange Rate Risk: frequently asked questions

What is the difference between transaction, translation and economic exposure?

Transaction exposure affects actual contracted cash flows such as payables and receivables. Translation exposure affects reported figures when foreign subsidiary accounts are converted. Economic exposure affects the present value of future operating cash flows because of long-term currency changes.

How is interest rate risk measured?

Common measures are the repricing gap, duration and modified duration, convexity and Value at Risk. Gap suits banks and floating-rate balances. Duration suits bond portfolios.

How can a company manage foreign exchange risk?

Internal methods include invoicing in the home currency, netting, and leading and lagging. External methods include forward contracts, money market hedges, futures, options and swaps. The choice depends on cost, certainty needed and the size and timing of the exposure.

Which hedge is best for a foreign currency payable?

There is no single best hedge. Compute the rupee cost under the forward and money market routes on the same date and choose the cheaper. An option is preferred if you want protection but also want to gain if the rate moves in your favour.